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March 26, 2013

Energy MLPs & Taxes: Under Scrutiny, but Still Churning Out Returns

Legislators continue to zero in on partnerships, though most energy firms seem likely to avoid major impact, experts say

With the ballooning of the federal deficit, politicians turned their eyes to the tax status of master limited partnerships and other investments. Fortunately for MLP investors, they have chosen not to let the air out of this group’s favorable tax situation—yet.

“MLPs, which do not pay taxes at the entity level, look to be an easy revenue target, but we believe it is highly improbable that they will see any major changes to their tax-favored status,” explained Connie Hsu, an analyst with Morningstar, earlier this month in an online commentary on the topic. “In the unlikely event that MLPs became subject to corporate taxation, however, we'd expect only a modest impact on valuations.”

Overall, says attorney Thomas Ford of the law firm Andrews Kurth in Houston, any major shift in the tax policies affecting energy-focused MLP would come when a major overhaul of the tax code takes place. “There shouldn’t be any one-off affecting MLPs,” he said in an interview with AdvisorOne.

The Ole K-1

Investors in MLPs benefit from the tax status of the partnerships but have to file a K-1 tax form rather than a 1099. That can raise eyebrows for some. But, experts say, there is compensation.

“The fact that retail investors (as well as institutional investors) actively invest in MLPs suggests that the complexity of the K-1 is obviously worth the trouble,” said Hsu, CFA.

“However, for certain accounts, the taxation—particularly retirement accounts—it may be undesirable because at a certain amount, MLP income (passed through to investors) may be taxable even though it’s held in a tax-deferred retirement account,” the Chicago-based analyst pointed out.

MLP supporters, like the National Association of Publicly Traded Partnerships, acknowledge the complexities of investing in MLPs via retirement accounts. The NAPTP and its members share information with investors on the merits of investing in MLPs in different types of accounts online and in public forums.

“The MLPs make the K-1s as easy as possible to deal with,” said Ford. “Most have online and other resources, like call centers, that are very accessible at tax time.”

As Hsu notes, though, some MLPs “are actually structured to circumvent some of the tax complications—for instance, Kinder Morgan Management LLC (KMR) and Enbridge Energy Management LLC (EEQ) represent the same underlying business cash flows as Kinder Morgan Energy Partners (KMP) and Enbridge Energy Partners (EEP), but they pay distributions in the form of additional units instead of cash.”

Though they have to file K-1s, MLPs investors get the advantage of putting their money not only into a tax-advantaged investment, but also into an inflation hedge, which has relatively generous distribution yields and growth prospects, according to Hsu.

“Distribution yields are hovering around 4-9% these days, with growth targets are in the mid-single digits, as well," she said. "Most of the MLPs under our coverage are trading around their fair values right now, but we think there is a good amount of upside potential with the domestic crude production boom we’re seeing now.”

Cloudy Tax Horizon

Still, there’s no hiding from the fact that the MLP structure—along with other special corporate tax issues—is on the minds of legislators.

Additional taxation “would jeopardize private investment in the development of domestic energy resources and potentially force even costlier public investment over the long term,” Hsu wrote in a report earlier this year. Hence, “MLPs have gained bipartisan support, as they have proved very successful in financing and building out energy infrastructure over the years.”

The Morningstar analyst adds that the current discussion about changes to how carried interest is taxed, for instance, does not include energy firms. Instead, it’s focusing on financial services structured as publicly traded partnerships.

More sweeping reforms of partnerships, though, are being discussed by U.S. Rep. Dave Camp, R-Mich., who is chairman of the House Ways and Means Committee.

Camp’s proposed rules, though, don’t zero in on publicly traded partnerships in the energy space specifically, however, and seem to be more focused on the real estate and finance fields.

Upside Seems to Beat Downside

Given this development and earlier measures put on the table, there’s no denying the focus on MLPs and related energy plays today.

“In various budget proposals, there have been proposals to decrease tax benefits from oil and gas development companies through depletion and intangible drilling costs,” Ford notes. These efforts, though, are largely aimed at the biggest of the big energy players.

The attorney shares that this type of “headline risk” associated with MLP investing is disclosed in detail in the prospectuses of the partnerships. “It hasn’t appeared to slow down the interest on the part MLP investors and others.”

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